Discounted Stock Options and Tax Code Section 409A: A Cautionary Tale

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Under Section A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan as defined in the regulations currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties.

Certain states also have adopted similar tax provisions. For example, California stock options section 409a an additional 20 percent state tax, interest, and penalties. Under Section A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement.

This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.

We are struggling with this right now with. We want to properly motivate our people currently contractorsbut we worry that too low of a strike price might signal low valuation to a future investor.

Yokum, Suppose deferred compensation comes in stock options section 409a form of convertible notes, convertible into a series B preferred stock to be issued. Does the fact that, until the series B closes, the risk of forfeiture is very high put the compensation outside the realm of A? If the notes are converted to the series B preferred, does the fact that the compensation is no stock options section 409a a legal obligation to pay put the deferral outside the realm of A?

If the person receives the convertible note for free, then it strikes me that there probably is a taxable event at that point in time. In a cash sale of a private company, what is the typical disposition of unvested options? Ijm — If the options are not assumed by the acquiror, unvested options fully vest and the option holder can either exercise and stock options section 409a merger proceeds or receive net cash equal to the price per share to the stock options section 409a minus the exercise price per share.

Or does the Board of Directors have the right to wave that requirement and take the risk? If the company has received venture financing or has revenues, then I think it is a must do item from a risk perspective.

The A valuation report shifts the burden of proof to the IRS to show that the exercise price was wrong. However, the company should prepare a valuation analysis on fair market value of the common stock to support the board conclusion on fair market value. Yokum, Our startup is struggling with the strike price on our first grants of options under our employee stock incentive plan.

Do you have any tips on a valuation analysis my board could use? We are pre-revenue, so any process at this point seems arbitrary. Burt — if the company did a Series A with institutional venture capital investors, then the company should get a A valuation. Of course, any rules of thumb like this are not proper accounting. The note is only convertible into class B preferred shares…no cash. The note was given in lieu of cash compensation. The company is pre-revenue and needs to raise funds thru the class B offering.

Until the B actually closes there is a high probability of bankruptcy and default. Does the fact that the company does not have to pay cash to redeem the note put the deferred comp. I would appreciate your advice on how to handle the situation of the A valuation being lower than the FASR valuation. Please read the disclaimers. I have heard of many situations where the auditors are rejecting A valuations. At the end stock options section 409a the day, I think that the company needs to appease the auditors with an acceptable FAS R valuation for accounting purposes, but that does not necessarily create an issue with the IRS as long as a A-compliant valuation backs up the option exercise price.

Companies used to take cheap stock charges in connection with IPOs, which tacitly admits that the option price was stock options section 409a low. When a consultant or a law firm agrees to work in exchange stock options section 409a options in a client, how do you determine the number of options you receive as a fee?

Any good option agreements online? Bill Mc — There are probably a few different ways to think about it. One is to simply express the number of shares as a percentage of the company.

Another way to think about it is in terms of value provided somewhat like warrant coverage. Perhaps even a different way to benchmark the size of option grant is to look at assumed in the money value and grant enough shares to provide the implied value. Generally, consultant options will be exercisable for a period between 5 and 10 years. They might be fully-vested upon grant upon completion of services and not dependent on continuous status as a service provider in order to be exercised.

However, some may be subject to continued services in stock options section 409a to be exercisable. An option grant is not a do it yourself exercise. There are various things that can be screwed up ranging from A compliance, securities law issues, failure to obtain valid approvals which may result in option backdating, etc.

How much does implementing an stock options section 409a stock option plan typically cost the company legal fees, admin. My company has three principals and five employees and we'd like to being offering equity incentives to key employees.

It doesn't seem like it should be that complicated. Basically, Stock options section 409a trying to figure out whether or not Stock options section 409a getting ripped off. Even if you incorporated DIY online and someone had to redo every doc, it would still be less that that range to redo everything and have a company with a stock option plan. Well, the A valuation issue is not going away. I believe the IRS has started scrutinizing the first of these arrangements. I believe there are quality appraisers out there including us who provide supportable, defendable and qualified A valuations.

There are also companies stock options section 409a cannot be considered completely independent valuation experts stock options section 409a they provide other services such as CFO rental or banking to stock options section 409a same clients they value.

The IRS is bound to hold such arrangements as non-independent. Stock options section 409a keywords in choosing a A provider ought to be: Due diligence and application of reasonable standards are what audit firms are looking for, and the IRS will look for. With outsourced talent and very stock options section 409a valuations, we find these two elements totally lacking.

Implications for discount stock options Under Section A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. Yokum, In a cash sale of a private company, what is the typical disposition of unvested options?

Hi Yokum, When a consultant or a law firm agrees to work in exchange for options in a client, how do you determine the number of options you receive as a fee? Hi Yokum — How much does implementing an employee stock option plan typically cost the company legal fees, admin. Thanks for any advice you can lend.

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In the startup ecosphere, stock options are commonplace. The tax rules for most options are relatively straightforward. And one that companies should consider carefully to avoid adverse tax consequences. According to the IRS, discounted stock options fall under Section A of the federal tax code governing nonqualified deferred compensation plans—i.

Stock options with an exercise price that is equal to or above fair market value when granted are exempt from A. The fine print includes an exception for short-term deferrals where the compensation is actually received within two and a half months of the end of the year in which there is no longer a substantial risk of forfeiture.

Such short-term deferrals are not subject to A. For stock options that are subject to A, option recipients have limited flexibility in when they can exercise their options without violating the rules. The rules allow recipients to exercise options based on a limited number of triggering events, including retirement or other separation of service, a change in control of the business, disability, death, an unforeseen emergency or at a previously specified date or year.

In general, the entire amount of compensation that has been deferred for the current and all previous tax years becomes taxable.

That compensation is also subject to a 20 percent penalty, plus interest. However, those rules were not tested in the courts—until this year, when the U. This ruling addresses various legal arguments with regard to the application of A, leaving the factual issue of whether the options were actually discounted to be determined at trial.

Sutardja is particularly significant because it is the first court ruling on the application of A to discounted stock options. As a result of Sutardja , we now have judicial affirmation of the following IRS positions:. A few strategies can help. If your company does not intend to discount the exercise price of its stock options, properly valuing them is central to avoiding the negative tax consequences of A.

In the Sutardja case, the company intended to grant its stock options at fair market value. A combination of lack of oversight and poor execution led the company to grant those options at less than fair market value, which may cost the recipients of those options many millions of dollars. Establishing fair market value can be problematical for startups and other privately held companies. Perhaps the safest way—and generally the most expensive way—to determine fair market value is to hire a qualified independent appraiser to perform the valuation.

The appraisal must be performed within 12 months of the option transaction to satisfy the first of three valuation safe harbor rules under A. Under the second safe harbor rule, startup companies can use someone other than an independent appraiser to perform the valuation, as long as the person has the requisite knowledge and experience and the valuation satisfies other criteria under A. The third safe harbor involves the use of a formula to determine the valuation, as prescribed under Section 83 of the federal tax code.

Separate from the safe harbor approaches, companies are allowed to use a reasonable application of a reasonable valuation method based on specific factors identified in A. But the committee did not formally ratify that grant until nearly a month later, when the fair market value was higher. The court determined that the date of ratification was the grant date, so the options were actually granted at a discounted price. By the time the company and recipient attempted to fix the error, it was too late as the options had been exercised.

Because of the impact that the grant date—and other elements of the process— can have on determining fair market value and general compliance with A rules, companies must develop and follow well-thought-out procedures governing the issuance of stock options. But for those companies that find themselves out of compliance with A, the IRS has published guidance in Notices , and on certain allowed corrective actions.

Ultimately, whether the problem can be corrected—and, if so, how much relief is available—is as complex as the rest of A. It depends on a number of factors, including the nature of problem and the timing of the correction.

For stock options that were erroneously granted at less than fair market value, it may be possible to amend the option agreement to eliminate the discount. Generally, the exercise price can be increased to the fair market value as of the grant date in the year the options were granted.

For option recipients who are not considered company insiders, that period is extended to include the following year. Under proposed regulations, it may also be possible to amend the option agreement prior to the year the options vest. Regardless, no corrective action is permitted for options that have been exercised. A Cautionary Tale" By peluang bisnis June 28, - 1: There arre alkso emerging video hosting sites for small business that are free.

How are customers responding too paying your sales prices. Being crewative with thee product will bring you success. And the small business owner who can really hekp them become a more educated consumer will bee the one who gets their business. Theee are more ways to get multiple streams of income then selling an info product.

Being creative with the product will bring you success. Thanks for putting this together, I found it to be really helpful. All businesses need to be aware of the rules applicable to the granting of stock options and SARs to their employees. Enter your email address to subscribe to this blog and receive notifications of new posts by email. Thoughts and commentary on the law of startups. Brought to you by Davis Wright Tremaine. About Disclaimer Privacy Policy. Consequences of the Sutardja Ruling Sutardja is particularly significant because it is the first court ruling on the application of A to discounted stock options.

As a result of Sutardja , we now have judicial affirmation of the following IRS positions: Discounted stock options are subject to Section A treatment as nonqualified deferred compensation The date an option is granted determines when compensation is considered to be earned. The date an option vests, not the date it is exercised, determines when the recipient has a legally binding right to the compensation. The date it vests also establishes the time at which the option is no longer considered to have a substantial risk of forfeiture.

The relevant period for applying the short-term deferral exclusion is not based on the date the options are actually exercised, but rather based on the period of time the options can be exercised under the terms of the plan. The Cautionary Part of the Tale A occupies some 80 pages of the federal tax regulations, which gives an indication of just how complicated it can be to either avoid it altogether or comply with its requirements. To Discount or Not to Discount: Fair Market Value A hinges on whether or not a stock option is discounted.

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